The 20-Times Strategy

Part two of Dan Denning’s analysis of the War on Terror and it’s subsequent implications for investors in defense technologies.

"For every state, war is always incessant and lifelong against every other state…For what most men call ‘peace,’ this is really only a name – in truth, all states by their very nature are always engaged in an informal war against all other states…"

Plato, Laws

Hackles are up…and all the president’s men are prepared to defend the State.

The amount of money Congress has appropriated to the Defense Department is staggering. And when you look at it item by item, it’s even more astonishing. Of 13 appropriations bills in Congress, only two have been passed into public law; the Defense bill and the Military Construction bill.

To get an appreciation for just how much money the United States spends on defense, consider some of the following numbers:

* The Air Force will spend $13 billion on 15 C-17 transport aircraft. The GDP of Mauritius, a current member of the U.N. Security Council, is $4.5 billion.

* The Army will spend $2.2 billion on appropriations for tracked vehicles, including equipment, ordinance, and spare parts.

* The Navy will spend $4.6 billion on procurement.

Incredibly, procurement of new weapons systems was the only portion of the defense budget that President Bush did not ask for an increase in. Congress increased it anyway. But the biggest increases in defense spending were in pay for military personnel and funding for current operations.

That figures to change in the next five years. The Bush administration has requested over $2.1 trillion in funding over the next five fiscal years. Annual defense spending would go from about $350 billion in 2002 to nearly $470 billion by 2007.

Right now, defense spending is about 3% of GDP. While it’s true the historic average is much higher, the United States now spends more on defense than the next 20 nations combined. Even a modest increase in the percentage of GDP dedicated to defense would send the total dollar figure well in excess of $500 billion a year – pretty much tantamount to a total declaration of war on the rest of the world for the indefinite future. Of course, the Bush administration has said in print that its aim is total military superiority. From its national security blueprint issued late this summer:

"The United States must and will maintain the capability to defeat any attempt by an enemy – whether a state or non-state actor – to impose its will on the United States, its allies, or our friends. We will maintain the forces sufficient to support our obligations, and to defend freedom. Our forces will be strong enough to dissuade potential adversaries from pursuing a military build-up in hopes of surpassing or equaling the power of the United States."

None of this is good news for pacifists. The Aerospace/Defense group as a whole sports a market cap of $119 billion. Yet the 5 largest of the 56 companies in the group – Boeing (BA), General Dynamics (GD), Honeywell (HON), Lockheed Martin (LMT), and Northrop Grumman (NOC) – have a combined market cap of $98.5 billion – nearly 80% of the sector’s total market value.

After these, 5 of the remaining 51 companies have market caps in excess of one billion dollars. Let me finish the math for you: this means that 46 of the 56 companies in this sector are fairly small companies. And the big institutional investors usually ignore stocks like these with market caps below $1 billion. This means there’s an opportunity for individual investors like you and me to find some attractively priced stocks.

In fact, this may be the perfect "contrarian play" for the existing environment. An article in Monday’s Wall Street Journal thoroughly trashes defense stocks. The article says the post 9-11 run-up in the big-cap defense stocks has run its course. It also claims that growth rates in the federal defense budget are likely to plateau in coming years.

I agree on the first count, but not on the second. The Defense budget will grow to over $500 billion in the next five years. Even in an age of budget deficits, Americans won’t skimp on defense…especially in the midst of permanent and unsettling threats from terrorists.

"Accumulated capital, not forced exactions, is what sustains wars," Thucydides wrote about 2300 years ago in The Peloponnesian War. This discussion of military capital goods comes in the context of a wider war on "terror." Capitalism – specifically the production of wealth-producing capital – does an unusually efficient job of building war machines.

As Victor Davis Hanson shows in Carnage and Culture, landmark battles in Western history are in large part due to the very real advantages the West derives from several factors. Those factors include free societies where individual rights – including property rights – are protected, a tradition of scientific inquiry, a preference for shock infantry battles backed by rigid discipline and fighting in formation, a recognition of individual initiative under changing circumstances, and the accountability of military leaders to both their soldiers and the States that send them to war.

Hanson summarizes his point this way: "Free capital is the key to making on any large scale what Cicero called the ‘the sinews of war,’ without which an army cannot muster, be fed, or fight. Capital is the wellspring of technological innovation, which is inextricably tied to freedom, often the expression of individualism, and thus critical to military success throughout the ages. That capitalism was born in the West, expanded through Europe, survived the alternate Western-inspired paradigms of socialism and communism, and found itself inextricably tied with personal freedom and democracy in its latest global manifestation explains in no small part Western military dominance from the age of Salamis to the Gulf War."

To make his point concrete, all you need to do is look at the battle of Midway from June 4 to June 8, 1942. The Japanese had four aircraft carriers heading for Midway. Their plan was to destroy the remnants of the already damaged U.S. Pacific fleet, take Midway, and eventually Hawaii, sealing off the Pacific theater of operations from the U.S. Navy.

But partly due to an eccentric bunch of code breakers, the Americans knew where the Japanese were. And all three American carriers simultaneously launched a wave of torpedo plane, dive-bomber, and fighter attacks. The fighters were supposed to give the slower torpedo planes cover. But in the confusion of locating and attacking the Japanese fleet, the fighters quickly over-flew the torpedo planes, leaving the latter totally without cover as each wave of torpedo planes located and attacked the fleet.

Forty-one TBD Devastator torpedo bombers attacked the Japanese fleet. But the planes were lucky if they could manage 100 mph at low altitude. And they carried only one weapon, a 1,000 lb. torpedo that often didn’t work. Their combat range was 175 miles. By contrast, the Japanese Zero fighters could attack from above at nearly 300 mph. The result: 35 of the 41 Devastators that attacked the fleet were shot down. Most of the men flying them knew they would be killed.

Yet because the Japanese fighters were either busy at sea-level shooting up the torpedo planes or refueling on the decks of the four carriers, they failed to notice the American dive bombers who finally arrived on the scene, totally unmolested. Within just a few hours, all four Japanese aircraft carriers – the Kaga, the Hiryu, the Akagi, and the Soryu – were sunk.

The Americans lost one carrier: the Yorktown. But the tide had turned in the Pacific theater. And the American war machine kicked into high gear.

By 1945, American industry was turning out one B-24 heavy bomber (with over 100,000 parts) every 36 minutes. And in less than four years, the United States had produced almost 300,000 aircraft and 87,620 warships. According to Hanson, "American industry was building entire new fleets every six months, replete with naval aircraft comparable in size to the entire American fleet at Midway."

The lesson is obvious: Western nations with free markets are capable of winning virtually any war. They have the money – the capital – to do so, because their economies are free, as are their people. This certainly bodes well for any war we might fight in the next six months.

What should give us pause today is that so much of our capital is now being consumed. America isn’t the country it was in 1942. Our GDP may be larger, but our economic habits are worse. If we fail to return to a model of saving and investing in capital goods – rather than consuming – we will impair our ability to fight and win the wars of the 21st century.

Regards,

Dan Denning,for The Daily Reckoning November 21, 2002

P.S. With all due respect to the Wall Street Journal, I believe their piece on Monday fails to take into consideration – or perhaps failed to correctly identify – the geopolitical implications of the war on terror.

Any intelligent investment forecast begins with a political forecast. And in this case – and almost all others with the federal government – deficit spending has broad political support in the context of an ideological war. An ideological war is exactly what this war on terror is becoming. And that alone should continue to drive defense spending…especially to the technology and niche manufacturers.

The weapons systems the Pentagon is funding particularly favor the companies I’ve selected in for the Strategic Investment portfolio.

Editor’s note: Dan Denning is the editor of Strategic Investment. You may remember Dan from his earlier investment advisory service. His focus on little-known stocks led investors to profits as high as 5,182%…as well as over 570% on Isle of Capri Casinos, 457% on Big Entertainment, 411% on Gentner Communications and 130% on Total Research Corporation. Today, Denning is the architect of Strategic’s winning portfolio – up across the board while Wall Street’s finest take it on the chin.

According to the International Herald Tribune, religious groups are launching a campaign to persuade Americans to drive more fuel-efficient cars.

"What would Jesus drive?" is the slogan.

Why they think Jesus would be especially concerned with fuel economy was not made clear. But of all the loony things done in His name, the drive for fuel economy seems among the least harmful.

Here at the Daily Reckoning, we have no idea what Jesus would look for in a set of wheels…or whether He would drive at all. The man walked all over the Holy Land in a pair of sandals and never complained. Would He have preferred a Civic or Silverado? Modesty forbids us from even taking a guess.

But behind the wheel of the WWJD campaign, however, must be people either without a shadow of a doubt…or a grain of sense. In a world drenched in sin and sorrow, they find nothing more pressing to worry about than MPG!

That is the baroque genius of America that we love so dearly; absurdity is no barrier to popularity. Why else would people buy stocks at 48 times real earnings? Or believe that they can borrow and spend their way to prosperity? Or pretend to know the automotive preferences of a man who was crucified 2000 years before the invention of the radial tire!

We admire absurdity, but this is almost too much. We are stuffed with it…like a man who has just finished an escargot-eating contest; we feel may burst at the seams.

The Dow rose yesterday, of course. We are in a bear market rally that could last another 4 to 6 months, according to Ian McAvity. Ian would be the first to admit that he is no more able to read tomorrow’s news today than we are. God neither whispers in his ear, nor ours; He does not tell us where the Dow is going anymore than he tells us which car Jesus would drive if He were headed down U.S. 95 at rush hour. We are not complaining about this lack of information. We take it for granted that He must have better things to do. And so we make do in a world of ignorance.

In the absence of advance information, we make a very modest assumption: that things in the future will work pretty much as they have in the past. Things tend to regress to the mean because that’s what things tend to do. Things are usually what they usually are. When they are something else, it is generally a good bet that they will go back to being usual before long.

Ian notes that nearly every big bubble is followed by a substantial rally. He figures that must be what we are seeing now.

Enjoy it while you can. Because Ian also notices that when the rally is over, prices usually fall…and may not recover for 10 years or more.

And now, more details from Wall Street from our intrepid man-on-the-scene, Eric Fry:

————

Eric Fry, reporting from the Big Apple…

– Yesterday, the stock market partied like it was 1999. Tech stocks soared arm-in-arm with bank stocks. Cisco jumped 5% and JP Morgan bounced 8%, just like they used to do – every day it seemed – in the halcyon, pre- millennial days of 1999.

– Unfortunately, it’s 2002; not 1999. Corporate profits are falling; not rising. And corporate balance sheets are in tatters. But that’s not stopping investors from loading up on yesterday’s heroes, as if it were still yesterday. The Dow surged 148 points to 8,623, while the Nasdaq leapt more than 3% to 1,419.

– Stock-hungry investors let nothing diminish their appetite, not even the news that housing starts tumbled a seasonally adjusted 11% in October, more than reversing September’s gains. The October drop was the steepest monthly decline in eight years. And that might not be a favorable omen for the housing market. No matter, yesterday was a day for buying stocks…period.

– What’s causing all this exuberance in the stock market? Should we credit the marvelous growth of derivatives for the latest bull run on Wall Street? If Alan Greenspan is to be believed, there is almost nothing that derivatives cannot do to advance the welfare of mankind, much less the stock market.

– The Chairman addressed the Council on Foreign Relations on Tuesday. His message in brief: "Derivatives are good, and good for you." According to the chairman’s speech, derivatives are just about the greatest things that ever happened to the world of finance, and we’d all be better off if we had a lot more of them coursing through the global financial system. Maybe Greenspan is right. But the world already has quite a few of these financial marvels.

– For better or worse, derivatives are accumulating in our macro-economic atmosphere like some sort of financial chlorofluorocarbon. Are they as inert as Alan Greenspan and banks like JP Morgan would have us believe? Or are they an inherently unstable compound that, like nitroglycerine, can explode if shaken a bit? No one knows. All we know is that total derivatives exposure within the banking system is expanding at a staggering rate.

– As Addison reported last week, The Bank for International Settlements (BIS) has determined that the total notional value of derivatives issued by the world’s financial institutions has nearly doubled over the last four years to $127.6 trillion. That seems like a pretty big number. Interest rate derivatives, which represent about $90 trillion of the total, are leading the growth spurt. That’s hardly a surprise when one realizes that interest rate derivatives help to fuel the mortgage industry.

– So what makes these financial widgets so marvelous?

– According to Greenspan, everything. For starters, as the chairman proudly explains, interest-rate derivatives have "facilitated the large debt-financed extraction of home equity that, in turn, has been so critical in supporting consumer outlays in the United States throughout the recent period of cyclical stress."

– In other words, if it weren’t for derivatives, very few folks would be able to suck out the sliver of equity remaining in their homes to buy cars and DVD players. But thanks to the vast deficit-spending that derivatives facilitate, consumers have continued borrowing and consuming, thereby preventing the economy from tanking.

– Maybe it will tank next year, but that’s another story. To be sure, derivatives can be very handy gadgets. But we suspect that they are subject to a law of diminishing returns. The unbridled growth of derivatives that Greenspan seems to crave is probably not something to wish for.

– Derivatives increase leverage throughout the financial system, and a little bit of leverage goes a long way. Greenspan, himself, said it best: "Derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an Achilles’ heel…Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked."

– How remote is a "remote possibility" anyway?…More tomorrow.

————

Back in Paris…

*** Here is something interesting. Even with ultra-low financing, low to moderate-income families are finding it harder to pay for housing. The number of such households where 50% or more of income goes to pay for housing has increased 67% in the last 5 years. The biggest group – 42% – with "critical" housing needs is in the suburbs, says the report.

Why? Because people are getting poorer in America. Median household income fell to $42,228 in 2001, down from $43,162 the year before. Yesterday’s ‘wealth,’ created by the stock market bubble, the New Era, and Greenspan’s easy credit, was an illusion. But the debt was real and is still with us today. Tomorrow, we will have to reckon with it.

*** "You are always talking about saving money," said my friend Michel at lunch yesterday. "But that is an illusion, too. It may be good for an economy, but what does the individual saver really gain? If a man spends his money on drinking and womanizing…at least, when he reaches his 80th birthday, he has nice memories and people to follow his casket to the grave. But if he saves his money until he is 80, what good is it? He has lost the desire…"

Sylvie, my French teacher, picked up the theme later in the day. "You never see a casket followed by a safe," she remarked.

*** Readers have been offering advice on how to help Edward’s academic career. "Try Ritalin," said one. "Don’t put him on drugs," said another, "just give him time to grow up."

*** We don’t have time to respond to every email, but we appreciate the advice and comments – even when they are critical. Daily Reckoning readers, we have noticed, are thoughtful, accomplished people with a sense of humor.

*** Many readers took offense at our remarks on Wild, Wonderful West Virginia. A typical letter:

"You obviously do not have knowledge of the contributions of the people of the state of West Virginia and its history. For a state of only 2 million in population, its contribution on the national and world stage is quite remarkable. To name just a few of the native West Virginians:

John Chambers – CEO of Cisco Systems – who at one time, however brief, was the top dog at the most valuable company in the history of the planet

John Nash – winner of the 1994 Nobel Prize in Economics

Chuck Yeager – the first man to break the sound barrier

Homer Hickam – a distinguished NASA engineer and author

As you might guess, I myself was born and raised in West Virginia. I currently live in the heart of Silicon Valley in San Jose, California and have had various technology- related positions in different parts of the world. However, my wife (a California girl) and I (who are fortunate enough to have the means to live anywhere on the planet) are currently building a home in West Virginia (built of stone with a respectable fireplace) because that is where we choose to raise our family. The "niceness" of the people you reference in your email is not to be underestimated when calculating the quality of life in a region. I personally have many friends that were raised in West Virginia, and then went on to remarkable academic (Harvard Law, Wharton Business School, etc…) and professional careers, who ultimately decided West Virginia was the place they most wanted to live.

Although West Virginia certainly does have aspects that I would like to see change, I suggest before you criticize an entire state you take the time to appreciate the high goals that were achieved by the people within that state."

*** Another reader finds fault with our appraisal of the military mind:

"I always enjoy your witty epistles, agreeing with nearly every thought and rumination. But you paint the military mind with too broad a brush.

My experience has been that warriors are exactly a cross section of the culture that produces them. Many, indeed, are blockheads, just like most of their civilian counterparts. But some – the best of the leadership – are more highly intelligent and perceptive than is generally recognized. Just like their exceptional civilian counterparts. My opinion is that they decide to subject themselves to their civilian masters, who are usually inferior in wisdom and especially integrity, because they know that our way of life and governance – established by our constitution – is dependant on their subjection to elected civilians.

After all, power is ultimately exercised at the muzzle of a gun. Great integrity and restraint is required of a man wielding the gun to avoid using it for selfish ends. I have great admiration for our military leaders who, while disagreeing vehemently with their civilian masters, do so silently and restrain themselves from using their power. I only wish they were ruled by politicians worthy of them.

For fairness and balance purposes, I will tell you that I am a Vietnam combat veteran, but not a career military man. I have seen plenty of ineptness and blockheadedness inside the military. But I have also seen the exceptional leader rise to the top, and sacrifice his personal beliefs and ideals on the altar of the welfare of the nation, even as politicians desecrate and destroy the constitution. Ours is a nation of historical exception. And it is only because the men with the ultimate power are more dedicated to the rule of law than they are to the use of power. In spite of our many warts, we are an anomaly in human history. In spite of the preponderance of blockheads military and civilian! God bless America. We may need it (His blessing) soon more than ever."

About Dan Denning:

Dan Denning is the author of 2005’s best-selling The Bull Hunter. A specialist in small-cap stocks, Dan draws on his network of global contacts from his base in Melbourne, Australia, and is a frequent contributor to The Daily Reckoning Australia.